One of the important behind-the-scenes participants in the operational world of exchange-traded funds is the custodian, whose job is to provide process integrity and investor security against a variety of risks. For financial advisors and their clients, knowing your investment is secure in the hands of a custodian should be an important factor in the selection process of an investment vehicle. Although this article is not exhaustive, it will highlight some of the major duties of a custodian.
The Safekeeping Of ETF Assets
An ETF has an account at the custodian where assets are held—and managed—for the benefit of the ETF shareholders. Assets move in and out of ETFs via the creation and redemption process, and the custodian and the transfer agent work in tandem in this process. Authorized participants and the transfer agent engage in the creation/redemption process to ensure accurate valuation and delivery of shares between parties. Most ETFs employ an “in-kind” creation and redemption process allowing shares of stock, for example, to move into the ETF’s custody account in exchange for shares of the ETF issued to the entity that brought those shares of stock to the custodian. Movement of shares in-kind typically follows a standardized and streamlined process to mitigate risk and provide operational and cost efficiencies. The custodian also works with the fund’s administrator, accountant and distributor, who all have a role to ensure the process goes as planned.
Providing Other Valuable Services
An ETF custodian can provide other valuable services to the fund as spelled out in the prospectus and with the fund board’s approval and oversight. Examples include securities lending and cash management. When an ETF institutes a securities lending program, the custodian works with the fund to balance risk/reward in the pursuit of additional revenue for the shareholders of the fund. The proceeds of a securities lending program are generally shared only between the securities lending agent and the shareholders of the fund. For example, the lending agent may keep 20% to 30% of the securities lending revenue for their role in facilitating the process, and then return the balance to the fund. These proceeds will add to the total return of the ETF realized by the shareholders. An ETF’s uninvested cash can also be managed by the custodian. The custodian will give the fund manager choices for investing cash that strike the appropriate balance between risk and reward.
Regulatory And Security Considerations
A custodian is typically, but not always, a federally registered bank. In cases when it is not, further oversight—including, but not limited to, “surprise” audits—may be imposed. Regardless, custodians must have an existing service model specific to ETFs that includes the proper tools, experience, operational and cost efficiency, as well as the ability to adapt to the needs of the changing regulatory environment. A robust cybersecurity program and a well-run compliance program is also essential. As ETFs continue to move into new asset classes and regions of the globe, the custodian will also must keep pace with the needs of the fund manager and the requirements of varied regulatory regimes.
Investment vehicles that use the services provided by a custodian give financial advisors and their clients added security. Nothing in the investment world is certain, but the valuable services provided by a custodian can mitigate unnecessary risks and provide an element of confidence.
Mike Castino is senior vice president, exchange-traded products at U.S. Bank Global Fund Services.